Price Elasticity Demand (PED)
Price Elasticity of Demand (PED) Price elasticity of demand is a numerical measure of the responsiveness of demand for a product following a change in the price of that product. The formula for price elasticity of demand (PED) is: PED = '% change in quantity demanded of a product ' '''% change in price of the product The value of PED usually negative (-) because demand curve shows an inverse relationship between the quantity demanded and price of the product. So when the price rises, the quantity demanded will fall; while when the price falls, the quantity demanded will rise. Therefore it is an inverse relationship. Even though PED has negative value, but usually in calculation, we can just ignore the negative sign. This is because the negative sign just showed that demand curve has inverse relationship. Example: Let’s say that a firm is producing 1000 units at price $100 each, however, because of certain circumstances, the price increases to $105 each and producing with an amount of 900 units. PED = (-) 10%/ 5% = (-) 2.0'''' Again, ignore the negative sign. The value of PED, which is 2, means that demand changes by 2% for every 1% change in price. According to the value of PED, we can deduce some classification of elasticity of PED. There are 5 classification of PED, which are perfectly inelastic, inelastic, unitary elastic, elastic, and perfectly elastic demand. When the value of PED is 0, then it is called as perfectly inelastic. The graph will be a straight vertical line with x-axis as quantity demanded and y-axis as price. This straight line means that no matter when the price is high or low, the quantity demanded will remain constant. In reality, there is no such goods or services that is characterized with this characteristic. When the value of PED is between 0 and 1, it is called as inelastic demand. The demand curve is steep with x-axis as quantity demanded and y-axis as price. As you can see on the graph, a large change in price will only slightly affect the change in demand. Instead of showing fall in revenue, an inelastic demand will show a rise in revenue (rise in revenue > fall in revenue). Goods that have inelastic demand usually are staple goods, such as rice, oil, salt, water, gas, etc. Because no matters how expensive are these goods, people still need it thus they will still purchase it in order to survive. When the value of PED is equals to 1, it is called as unitary elastic. The graph is directly proportional. It means that the change in price will give the same change in demand. So the total sales revenue will be constant. When the value of PED is greater than 1, it is called as elastic demand. The demand curve is gradual (not steep) with x-axis as quantity demanded and y-axis as price. As you can see on the graph, a large change in price will also give a big change in demand. In this case, if the company increases the price, then it will show a fall in revenue because the shaded area of fall is greater than rise in revenue. It depends on the objective of the business. If the business wants to increase the sales revenue, then it will be suitable if the business lower its price to secure the greatest possible market share. The examples of elastic goods can be anything that is not necessities goods to us, such as candy, chocolate, perfume, etc. When the value of PED is infinity, it is called as perfectly elastic demand. The graph will be a straight horizontal line with x-axis as quantity demanded and y-axis as price. This graph means that there will be a large infinite amount of demand at one point of price level, but after the price is slightly increase, the demand will directly fall to zero. In reality, there are no such products that have this characteristic. Factors '''That Determine Price Elasticity 1. How necessary the product is The more the necessary the products, such as water, salt, oil; the more the demand curve will be inelastic. It means that it is less reactive to price changes. While for normal goods, they tend to have an elastic demand that is more reactive to price changes. 2. How many similar competing products or brands there are More competing products means that there are more substitute goods available in the market. For example, if there are an increase in the price of product A, then people will likely to move and buy product B, which has lower price. The demand is said to be more elastic. While as the number of competitors is decreasing, the demand will probably become more inelastic. 3. The level of consumer loyalty Usually, products that have already produced under a successfully branded business, let’s say ‘Coca Cola’, will likely to gain more consumers’ loyalty thus increase in price will only slightly affect the demand of the products. We can use promotion campaigns and advertising as the methods to gain consumers’ loyalty. 4. The price of the product as a proportion of consumers’ incomes Products that have cheap price in the market will be less reactive to increase in price, because it only takes small proportion of individual’s income. Therefore the products will likely to have inelastic demand. Applications '''of price elasticity of demand 1. Making more accurate sales forecast The value of PED allows forecast demand to be calculated. So if a company is going to increase their product price, they can calculate the approximate falls in quantity demanded thus they could decide what is the best action to take. For example, if the value of PED is (-) 0.5. It means that there will be 5% change in the quantity demanded when there is an increase of 10% in price. So if a company producing at 10.000 units, then after the price increased, they will give forecast sales level of 9500 per unit intervals. 2. Assisting in pricing decisions If an airline is considering the use of PED calculation, then they can increase the price of the tickets when it is due on the peak of holiday thus the demand will tend to be inelastic. While if the flight is located in normal days, then it will better if the airline lower the price or setting standard price considering that the demand is likely to be elastic. This strategy is known as price discrimination. Evaluation '''of price elasticity of demand The use of PED has three main limitations: 1. PED calculation is ceteris paribus. It assumes that the condition remains the same and constant. Therefore calculating the accurate PED will be almost impossible. For example, if a company decided to increase its price, they have prepared to experience the consequence, which is fall in demand. However, if suddenly there is a general increase in people’s income, the demand could even rise, instead of fall. 2. PED calculation that even only involves price changes still has another limitation. In which it can easily become outdated due to the fast change in market condition. For example, if there is another competitor enters the market, the PED should be recalculated again. 3. It is not easy to calculate PED. As explained before, this is because the data could be outdated and the market conditions might have changed. Besides that, in the case of new product development, the company needs to identify the quantities that a sample of population would like to purchase at certain price. Therefore it is not easy, especially to get the accurate calculation. Category:PED Category:Elaticity Category:Inelastic Category:Elatic Category:Price Category:Calculation Category:Business Category:Marketing